Production Efficiency

One of the three conditions necessary for an economy to
be economically efficient is that it be on its
production-possibilities frontier. If it is not on the
production-possibilities frontier, more could be produced
with the given resources and technology. Because greater
production would increase value, any position below the
production-possibilities frontier is inefficient. Notice
that a great many points satisfy this condition of
production efficiency--every point on the
production-possibilities frontier is production
efficient.

To be on the production-possibilities frontier, all
resources must be used. Unemployed resources indicate that
more goods and services could be produced, which means that
the economy was not on the frontier initially. In addition,
resources must be used properly. If society randomly assigns
people to jobs or if it assigns jobs on the basis of
political reliability, it will not produce as much as it
could. It will require some people with little intellectual
ability to perform jobs that require great intellectual
ability, and it will require some people with little
strength and endurance to perform jobs that demand much
strength and endurance. If switching people among jobs can
increase output, the original situation was not on the
production-possibilities frontier and thus not economically
efficient.

This requirement that resources must be used properly can
be stated more technically. Production efficiency requires
that an equimarginal principle be satisfied. It requires
that the ratio of marginal products for any two resources be
the same for all products. The table presents a case in
which this condition is not met. Here the ratio of the two
marginal products for the production of widgets is (5/5) or
1 and the ratio of the two marginal products for getwids is
(6/4) or 1 1/2.

Production
Inefficiency

Marginal product of capital is:

5 widgets or 6 getwids

Marginal product of labor is:

5 widgets or 4 getwids

To show that the situation in the table is not
production-efficient, consider what happens if a getwid
producer trades a unit of labor to a widget maker for one
unit of capital. The widget maker will have no change in
output as a result. Reducing capital by one unit cuts output
by five, but this is offset by the five widgets the extra
labor adds. However, there will be more getwids. The extra
unit of capital adds 6 getwids, whereas the loss of a unit
of labor subtracts 4 getwids. There is a net gain of two
getwids. Because the amount of production after the exchange
of resources was more than the original amount, the economy
could not have been on the production-possibilities frontier
originally. Further, because more output has more value to
consumers, the original use of resources was less efficient
than the use of resources after the trade.

As a result of the trade of resources, marginal products
should change. Because more capital is being used in
producing getwids, its marginal product in getwid production
should drop (by the law of diminishing returns). Because
more labor is being used in producing widgets, its marginal
product in widget production should drop. Hence some
exchange of resources should bring the ratios of marginal
products to equality.